A Global Approach to Real Assets

Faced with volatility in both equity and fixed income markets, global real assets can be a useful tool for investors seeking to enhance diversification and lower risk in their portfolios, while at the same time providing a steady income stream.

A Real Challenge in Markets

Global real assets provide attractive characteristics for investors wanting to add inflation-protected income, diversification and greater risk-return efficiency to their traditional portfolios. Real assets, which are available to investors through both publicly listed and privately held investment markets, can include real estate, infrastructure, agriculture, timberland. While investors should always think carefully about introducing less-liquid assets to their portfolios in large quantities, analysis shows that an allocation to real assets can be beneficial to both risk-adjusted and total returns.

The last 25 years have been challenging for those responsible for managing Canadian’s pension plans. This period has brought multiple financial crises, stock market bubbles, global pandemics, and steadily declining interest rates that are now at an all-time low. In this environment, it is a testament to the abilities of the managers of Canada’s largest pension plans that they have been able to meet pensioners’ income needs through prudent portfolio construction. A key characteristic of these plans is their early and enthusiastic adoption of real assets.

Today’s environment is no less daunting than the previous quarter century. Canadian investors and their advisors face many challenges in constructing portfolios to prosper in the current global market environment. Yields on traditional government bonds are at all-time lows in many markets, while dividend yields on stocks remain below historical averages, meaning that stable income is often hard to come by. More recently, inflation, a long-discounted risk, has shown signs of returning. At the same time, correlations between stocks in certain sectors are persistently high, introducing undesired concentration risk to the ‘traditional’ asset allocation that has historically relied on these investments for capital growth.

For these reasons, many sophisticated investors have made their first forays into real assets, and typically they have focused on a specific asset class or strategy. More recently, however, investors have been drawn to the attractive benefits of diversifying across their real asset portfolios.

It is in this context that we at Franklin Templeton believe a strong case can be made for a portfolio allocation that includes a globally diversified portfolio of core, income producing real assets.

What Are Real Assets?

At Franklin Templeton, we define real assets as investments where the economic drivers of return are generated by the characteristics of tangible assets, such as land or physical improvements on land, which are owned by the investor.

Within that broad definition, we divide real assets into the following categories:

• Real Estate: commercial and residential property occupied by tenants who are obliged to pay rent under a lease agreement.
• Infrastructure: assets which are essential for societies to operate and grow. Owners and operators of infrastructure assets are often paid a rate of return under a long-duration contract, in most cases with a government entity.
• Agriculture: farmland, leased to an operator, on which crops or livestock are grown for eventual harvest and sale.
• Timberland: forestry land, leased to an operator, on which trees are grown for eventual harvest and sale.

Why Invest in Real Assets?

Inflation Protected Income

Core real assets, those that are fully developed and contracted or leased to high-quality tenants or operators, have historically offered a stable and predictable income stream. This comes from long-term leases in place with the tenants and operators of the assets, providing investors with cash yields. The structure of these leases and the characteristics of certain real assets also allow the income to grow in value during times of economic growth and provide inflation-hedging characteristics, thus protecting portfolios from long-term capital erosion

Diversification

Real assets offer returns with relatively low correlation to traditional asset classes like listed equities and bonds. An investment in real assets can therefore provide diversification benefits to a traditional portfolio. As real assets exhibit lower volatility than traditional assets, it allows them to reduce overall portfolio volatility.

Why Invest Globally?

Real assets, like many investment asset classes, are cyclical in value. However, these valuation cycles are often driven by local, micro-economic factors. This means that a globally diversified portfolio can provide powerful natural diversification, which in turn helps to preserve capital.

In Figure 1, we can see the correlation of traditional stocks and bonds with private real estate assets around the globe. It is clear that real assets exhibit low-to-negative correlation to traditional assets and across real asset markets.

Publicly Listed or Privately Held?

Real assets are available to investors through both publicly listed and privately held investment markets. Private real assets are traded infrequently and are typically large in size, requiring significant amounts of capital. Investors who cannot own these assets directly are able to access them through private funds, which have varying holding structures but are generally only infrequently liquid. Private real assets exhibit low volatility relative to listed securities and therefore provide the greatest diversification, but at the cost of immediate liquidity.

Public companies that own and operate real assets such as real estate, infrastructure and timberland are available for investors through equity shares that are traded daily on the stock exchange. Over the long term, these investments behave similarly to private real assets, but in the short to medium term investors are exposed to price volatility and equity market ‘beta’ as the trade-off for immediate liquidity.

Franklin Templeton believes the optimal solution for many investors is to blend public and private real assets to optimize the desired investment characteristics, while still preserving a degree of liquidity.

Benefits of an Allocation to Real Assets

Earlier we discussed the diversification benefits that real assets can bring to a traditional portfolio of listed equities and bonds.

In Figure 3, we show that including real assets in a traditional moderate portfolio will improve the overall risk and return efficiency. By combining a ‘traditional’ portfolio with a globally diversified portfolio of real assets over a ten-year period, an investor can build a less volatile, outperforming portfolio.

A Real Option for Income & Returns

Global real assets provide an attractive set of characteristics for investors wanting to lower total portfolio risk, add inflation protected income, and diversify traditional portfolios. While investors should think carefully about introducing less liquid assets to portfolios in large quantities, analysis shows that an allocation to real assets can be beneficial in both risk-adjusted and total returns.